This paper shows how to decompose the dollar profit earned from an option into two basic components: i) mispricing of the option relative to the asset at the time of purchase; and ii) profit from subsequent fortuitous changes or mispricing of the underlying asset. This separation hinges on...

We investigate incentive effects of a typical hedge fund contract for a manager with power utility. With a one-year horizon, the manager displays risk taking that varies dramatically with fund value. We extend the model to multiple yearly evaluation periods and find that the manager's risk...